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CHAPTER 9

CHAPTER 9. MANAGING ACCOUNTING EXPOSURE. CHAPTER OVERVIEW . I. MANAGING TRANSACTION EXPOSURE II. MANAGING TRANSLATION EXPOSURE III. DESIGNING A HEDGING STRATEGY. PART I. MANAGING TRANSACTION EXPOSURE. I. METHODS OF HEDGING A. Forward market hedge B. Money market hedge

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CHAPTER 9

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  1. CHAPTER 9 MANAGING ACCOUNTING EXPOSURE

  2. CHAPTER OVERVIEW • I. MANAGING TRANSACTION EXPOSURE • II. MANAGING TRANSLATION EXPOSURE • III. DESIGNING A HEDGING STRATEGY

  3. PART I. MANAGING TRANSACTION EXPOSURE • I. METHODS OF HEDGING • A. Forward market hedge • B. Money market hedge • C. Risk shifting • D. Pricing decision • E. Exposure netting • F. Currency risk sharing • G. Currency collars • H. Cross-hedging • I. Foreign currency options

  4. MANAGING TRANSACTION EXPOSURE • Central idea: Hedging • Hedging a particular currency exposure means establishing an offsetting currency position • whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge

  5. MANAGING TRANSACTION EXPOSURE • Managing transaction exposure: • A transaction exposure arises whenever a company is committed to a foreign currency-denominated transaction. • Protective measures include using: forward contracts, price adjustment clauses, currency options, and HC invoicing.

  6. MANAGING TRANSACTION EXPOSURE • A. FORWARD MARKET HEDGE • 1. consists of offsetting • a. a receivable or payable in a foreign currency • b. using a forward contract: • - to sell or buy that currency • - at a set delivery date • - which coincides with receipt of the foreign currency.

  7. MANAGING TRANSACTION EXPOSURE • 2. True Cost of Hedging: • a. The opportunity cost depends upon • future spot rate at settlement • b. Shown as • f1 - e1 • e0 • where f1 = forward rate • e0 = spot rate • e1 = future spot rate

  8. MANAGING TRANSACTION EXPOSURE • B. MONEY MARKET HEDGE • 1.Definition: • simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash flow

  9. MANAGING TRANSACTION EXPOSURE • C. RISK SHIFTING • 1. home currency invoicing • 2. zero sum game • 3. common in global business • 4. firm will invoice exports in strong currency, import in weak currency

  10. MANAGING TRANSACTION EXPOSURE • C. RISK SHIFTING (con’t) • 5. Drawback: • it is not possible with informed customers or suppliers.

  11. MANAGING TRANSACTION EXPOSURE • D. PRICING DECISIONS • 1. general roles: on credit sales connect foreign price to home price using forward rate, but not spot rate. • 2. if the dollar price is high/low enough the exporter/importer should follow through with the sale.

  12. MANAGING TRANSACTION EXPOSURE • E. EXPOSURE NETTING • 1. Protection can be gained by selecting currencies that minimize exposure • 2. Netting: • MNC chooses currencies that are not perfectly positively correlated. • 3. Exposure in one currency can be • offset by the exposure in another.

  13. MANAGING TRANSACTION EXPOSURE • F. CURRENCY RISK SHARING • 1. Developing a customized hedge contract • 2. The contract typically takes the form of a Price Adjustment Clause, whereby a base price is adjusted to reflect certain exchange rate changes.

  14. MANAGING TRANSACTION EXPOSURE • F. CURRENCY RISK SHARING (con’t) • 3. Parties would share the currency risk beyond a neutral zone of exchange rate changes. • 4. The neutral zone represents the currency range in which risk is not shared.

  15. MANAGING TRANSACTION EXPOSURE • G. CURRENCY COLLARS • 1. Contract • bought to protect against currency • moves outside the neutral zone. • 2. Firm would convert its foreign • currency denominated receivable • at the zone forward rate.

  16. MANAGING TRANSACTION EXPOSURE • H. CROSS-HEDGING • 1. Often forward contracts not available • in a certain currency. • 2. Solution: a cross-hedge • - a forward contract in a related currency. • 3. Correlation between 2 currencies is • critical to success of this hedge.

  17. MANAGING TRANSACTION EXPOSURE • I. Foreign Currency Options • When transaction is uncertain, currency options are a good hedging tool in situations in which the quantity of foreign exchange to be received or paid out is uncertain.

  18. MANAGING TRANSACTION EXPOSURE • I. Foreign currency options • 1. A call option • is valuable when a firm has offered to buy a foreign asset at a fixed foreign currency price but is uncertain whether its bid will be accepted.

  19. MANAGING TRANSACTION EXPOSURE • 2. The firm can lock in a maximum dollar price for its tender offer, while limiting its downside risk to the call premium in the event its bid is rejected.

  20. MANAGING TRANSACTION EXPOSURE • 3. A put option • allows the company to insure its profit margin against adverse movements in the foreign currency while guaranteeing fixed prices to foreign customer.

  21. PART II. MANAGING TRANSLATION EXPOSURE • I. MANAGING TRANSLATION EXPOSURE • A. 3 options • 1. Adjusting fund flows • altering either the amounts or the currencies of the planned cash flows of the parent or its subsidiaries to reduce the irm’s local currency accounting exposure.

  22. MANAGING TRANSLATION EXPOSURE • 2. Forward contracts • reducing a firm’s translation exposure by creating an offsetting asset or liability in the foreign currency.

  23. MANAGING TRANSLATION EXPOSURE • 3. Exposure netting • a. offsetting exposures in one currency with exposures in the same or another currency • b. gains and losses on the two currency positions will offset each other.

  24. MANAGING TRANSLATION EXPOSURE • B. Basic hedging strategy for reducing translation exposure: • 1. increasing hard-currency(likely to appreciate) assets • 2. decreasing soft-currency(likely to depreciate) assets • 3. decreasing hard-currency liabilities

  25. MANAGING TRANSLATION EXPOSURE • 4. increasing soft-currency liabilities • i.e. reduce the level of cash, tighten credit terms to decrease accounts receivable, increase LC borrowing, delay accounts payable, and sell the weak currency forward.

  26. PART III. DESIGNING A HEDGING STRATEGY • III. DESIGNING A HEDGING STRATEGY • A. Strategies • a function of management’s • objective • B. Hedging’s basic objective: • reduce/eliminate volatility of • earnings as a result of exchange • rate changes.

  27. DESIGNING A HEDGING STRATEGY • C. Hedging exchange rate risk • 1. Costs money • 2. Should be evaluated as any other • purchase of insurance. • 3. Taking advantage of tax • asymmetries lowers hedging costs.

  28. DESIGNING A HEDGING STRATEGY • D. Centralization v. Decentralization • 1. Important aspects: • a. Degree of centralization • b. Responsibility for developing • c. Implementing the hedging • strategy. • 2. Maximum benefits accrue from • centralizing policy-making, formulation, and implementation.

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